Chapter 9

Mechanics of Options
Markets

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 1
 What is an option?
 An option is a financial instrument that gives the holder (buyer)
the right to buy or sell an underlying asset from or to writer
(seller) by a certain date for a certain price .

 The buyer pays the premium (price of the option) to the seller
(writer) for the right to buy or sell the underlying asset.

 If the buyer chooses to exercise his right to buy or sell the asset,
the seller of the option has the obligation to deliver or take delivery
of the underlying asset.

 Exercise price, or strike price: the fixed or certain price at which

the underlying asset can be bought or sold.
 At expiration: if the option is not exercised, the option will expire.
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Review of Option Types
A call is an option to buy.

A put is an option to sell.

A European option can be exercised only at

the end of its life.

An American option can be exercised at any

time
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Option Positions
 Call Option:
 Long call: the buyer of a call option has the right to buy the
underlying asset.

 Short call: the seller of a call option has the obligation to sell the
underlying asset.

 Put Option:
 Long put: the buyer of a put option has the right to sell the
underlying asset.

 Short put: the seller of a put option has the obligation to buy the
underlying asset.
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Payoffs/intrinsic value of an option
Notations
K: exercise price of an option
ST: price of the underlying asset at time T

T: time to maturity/expiration
c: price of an European call option at time 0
C: price of an American call option
p: price of a an European put option at time 0
P: price of an American put option
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 Long Call
Payoff and profit from buying one European call
option: option price = $5, strike price = $100, option
life = 2 months

Profit ($)
30 Payoff

Profit
20

10 Terminal
70 80 90 100
stock price ($)
0
-5 110 120 130

+ Payoff = Max (0, ST-K)

+ Profit = Max (0, ST-K) - c
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 Short Call
Profit from writing one European call option: option
price = $5, strike price = $100
Profit ($)

5 110 120 130

0
70 80 90 100 Terminal
Payoff
-10 stock price ($)
Profit

-20

-30

+ Payoff = - Max (0, ST-K)

+ Profit = - Max (0, ST-K) + c
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 Long Put
Profit from buying a European put option: option
price = $7, strike price = $70

Profit ($)
30

20

10 Terminal

stock price ($)

0
40 50 60 70 80 90 100
-7

+ Payoff = Max (0, K-ST)

+ Profit = Max (0, K-ST) - p
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 Short Put
Profit from writing a European put option: option price
= $7, strike price = $70

Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100

-10

-20

-30
+ Payoff = - Max (0, K-ST)
+ Profit = - Max (0, K-ST) + p
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Payoffs from Options
What is the Option Position in Each Case?

K = Strike price, ST = Price of asset at maturity

Payoff Payoff

K
K ST ST
Payoff
Payoff
K
K ST ST

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 10
Assets Underlying
Exchange-Traded Options
Page 198-199

Stocks, Stock Indices.

Bonds,
Foreign Currency
Interest rates.
Options on futures: the underlying asset is a
futures.
Commodity options: underlying assets are
commodities such as oil, gold, wheat...
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Specification of
Exchange-Traded Options

Expiration date
Strike price
European or American
Call or Put (option class)

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 12
 In the money is to

Terminology: exercise the option

Out of the money is to not
exercise the option
 In the Money: exercise of the option would result in a positive
payoff
Call: if ST is more than K
Put: if K is more than ST

 Out of the Money: exercise of the option would not result in a

positive payoff
Call: if ST is less than K
Put: if K is less than ST

 At the Money: exercise price = market price of the underlying

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asset ( not exercise)
 Options, Stock Dividends & Stock Splits
Stock split occurs when the existing shares are “split” into
more shares.
Example: 3-for-1 stock split means that three new shares
are issued to replace one existing share.
+ Does the split have any effect on the total value of the
company? No
+ Does the split affect the stock price? Decrease the stock
price
+ Does the split affect the number of share outstanding?
Increases number of shares

Suppose you own N options with a strike price of K :

When there is an n-for-m stock split:
• the strike price is reduced to K*m/n
• the no. of options is increased to N*n/m
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Dividends & Stock Splits
(continued)
Consider a call option to buy 100 shares for
$20/share
How should terms be adjusted:
for a 2-for-1 stock split?
 no. of options is N*n/m
= 100* 2/1 = 200
 strike price is K*m/n
= 20*1/2= 10

15
 Option Trading
Options can be traded both on exchange-traded markets
such as the Chicago Board Options Exchange (CBOE:
http://www.cboe.com) and over-the-counter markets.

Margins are required when options are sold.

This is because the seller always have a obligation and thus

is required to maintain funds in a margin account)

A naked option is an option that is not combined with an

offsetting position in the underlying stock.

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 Margins (Page 205-206)
When a naked option is written the margin is the greater of:
A total of 100% of the proceeds of the sale plus 20% of
the underlying share price less the amount (if any) by
which the option is out of the money
A total of 100% of the proceeds of the sale plus 10% of
the underlying share price (call) or exercise price (put)
For other trading strategies there are special rules

17
Warrants
Warrants are options that are issued by a corporation or a
financial institution.

A common use of warrants by a non-financial corporation is

at the time of a bond issue. The corporation issues call
warrants giving the holder the right to buy its own stock for
a certain price at a certain future time and then attaches
them to the bonds to make the bonds more attractive to
investors
When call warrants are issued by a corporation on its own
stock, exercise will usually lead to new treasury stock being
issued
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Employee Stock Options (see also Chapter 15)
Employee stock options are a form of
remuneration issued by a company to its
executives
They are usually at the money when issued
When options are exercised the company
issues more stock and sells it to the option
holder for the strike price
Expensed on the income statement
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 19
Convertible Bonds
Convertible bonds are regular bonds that can
be exchanged for equity at certain times in
the future according to a predetermined
exchange ratio
Usually a convertible is callable
The call provision is a way in which the issuer
can force conversion at a time earlier than the
holder might otherwise choose

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 20